Oil prices have dominated the headlines recently by plunging to a four-year low. Despite the fact that this caught most people by surprise, everyone seems to want to know where oil prices will go next. We've seen opinions ranging from oil going to zero, to a multimillion bullish bet. But, before you take those opinions too seriously take one look at this crazy oil price chart.
What you are looking at is the percentage change in the price of oil over the past few decades. That chart tells us that oil prices are borderline crazy. Rocketing to all-time highs one moment only to fall back to Earth soon thereafter. What this chart is really telling us is that when it comes to oil prices we should expect prices to do unexpected things when we least expect it.
Why are oil prices so crazy?
Because oil is a commodity, its price is largely driven by supply and demand. However, it's not that simple as oil prices can be driven to a greater degree by the fear of something that could possibly -- if everything goes right, or really wrong -- impact supply and demand. It's kind of like the butterfly effect on steroids. However, here we have an oil market that sees that first flutter of chance on one side of the globe and then makes preparations by radically adjusting oil prices for the tornado that it thinks will wreak havoc on supply or demand.
We see this effect all the time. In 2011, unrest in Libya caused its oil production to drop. That flutter in the oil market caused the spot price of Brent crude oil to spike. A few weeks later, American consumers were paying more money at the pump for a gallon of gasoline.
Now, in the grand scheme of things, Libya isn't a major oil producer. At its peak, the country pumped out about 1.65 million barrels of oil per day. For perspective, the Eagle Ford Shale in Texas by itself pumps out that much oil each day. The bigger issue, and the one driving the 2011 surge in oil prices, was the worry that the unrest in Libya could have boiled over to engulf the entire Middle East -- taking a much larger supply of oil offline. So basically, American drivers at that time were forced to pay more at the pump because of the worry that things would go from bad to much worse.
We are seeing the opposite worry today as tepid demand for oil in Asia is causing crude oil prices to plunge. Not only are oil supplies from Libya coming back online, but oil production in the U.S. is surging. The fears are growing that an imbalance between supply and demand will only continue to grow worse in the future as more oil supplies could flood the market. Again, we see the oil market reacting with a rapid correction in oil prices that was all started with the flutter of a slowdown for oil demand from Asia.
The first thing we need to keep in mind is that oil prices can move rapidly in either direction with little notice. That makes it tough for investors who own energy stocks as these stocks tend to tag along with the craziness that we see in oil prices. This is why investors need to be careful never to become too bullish or bearish on oil stocks, because the price of oil is just too unpredictable for making a really strong case one way or the other. Instead, investors should focus on how well a company can withstand an oil price shock as it can make it easier to hold tight when the oil markets are going crazy.
The second thing the crazy oil price chart is trying to tell us is to not take oil price forecasts too seriously. We never know when unrest in an oil producing country will happen nor can we accurately predict when demand for oil in Asia will pick up. Because of this, investors always need to expect the unexpected when it comes to investing in oil stocks.